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INTRODUCTION

Each month, the U.S. Bureau of Labor Statistics (BLS) releases an estimate of the rate of inflation in the United States for the previous month. This Case Study focuses on the BLS report of the Consumer Price Index (CPI) in October, 2008.

BLS announcement, November 19, 2008: Consumer Price Index: October 2008

"The Consumer Price Index for All Urban Consumers (CPI-U) decreased 1.0 percent in October, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The October level of 216.573 (1982-84=100) was 3.7 percent higher than in October 2007.

The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) decreased 1.3 percent in October, prior to seasonal adjustment. The October level of 212.182 (1982-84=100) was 3.8 percent higher than in October 2007.

The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) decreased 0.8 percent in October on a not seasonally adjusted basis. The October level of 124.784 (December 1999=100) was 3.3 percent higher than in October 2007. Please note that the indexes for the post-2006 period are subject to revision.”

TASK

  • Identify the current rate and change in the rate of inflation in the U.S. in October 2008.
  • Analyze and compare various measurements of inflation, including the consumer price index.
  • Identify the factors that influenced the rate of inflation during October, 2008.
  • Describe how inflation and deflation affect individuals, families and different groups in the economy.

PROCESS

The BLS announcement tells us that consumer prices in the United States have decreased and, if the trend continues, will result in the phenomenon called “deflation.” It seems to confirm a change in the direction of prices that was first hinted in the report for the month of September.

The announcement added that the October decrease was “the largest one month decrease since publication of seasonally adjusted changes began in February 1947." Compared to a year ago, the October index was up 3.7 percent (annual rate). Just two months ago, the reported annual rate of CPI change was over one percent higher.

Components of the CPI:

  • Energy: The energy index fell 8.6 percent in October.
     
  • Food: The food index increased 0.3 percent in October.
     
  • Housing: The housing index was virtually unchanged in October.
     
  • Transportation: The transportation index declined sharply in October, falling 5.4 percent as several major components of the index declined significantly.
     
  • Apparel: The index for apparel fell 1.0 percent in October.
     
  • Medical Care: The medical care index rose 0.2 percent in October.
     
  • Recreation: The index for recreation increased 0.1 percent in October.
     
  • Education and Communication: The index for education and communication rose 0.2 percent in October.
     
  • Other: The index for other goods and services rose 0.3 percent in October.

Figure 1 shows a breakdown of the CPI changes by major expenditure category for the last three months, August through October, 2008

Table 1. Percent changes in CPI All Urban Consumers (seasonally adjusted)

Expenditure
Category

Changes from proceeding month

Compound Annual Rate for 3 mos. Ended

Unadjusted for 12 mos. Ended

 

Aug. 2008

Sept. 2008

Oct. 2008

Oct. 2008

Oct. 2008

All items

-.1

0

-1.0

-4.4

3.7

Food & Beverages

.6

.5

.3

5.7

6.1

Housing

-.1

-.1

0

-.9

3.2

Apparel

.5

-.1

-1.0

-2.4

.3

Transportation

-1.5

-.6

-5.4

-26.2

4.2

Medical Care

.2

.3

.2

2.9

2.8

Recreation

.5

.2

.1

3.4

2.2

Education/Communication

.2

.1

.2

2.1

3.4

Other goods and services

.2

.2

.3

2.9

4.1

Special indexes:

 

 

 

 

 

   Energy

-3.1

-1.9

-8.6

-43.1

11.5

   Food

.6

.6

.3

5.8

6.3

   All items less food

   and energy

.2

.1

-.1

1.1

2.2

What is the Consumer Price Index?

The Consumer Price Indexes (CPI) is a monthly measurement of changes in the prices paid by urban consumers for a representative 'market basket' of goods and services. An increase in the CPI from one month to another may be evidence of 'inflation' in the price level or a reduction in purchasing power.

For details about the make-up of the CPI “market basket,” see the BLS online publication “Consumer Price Index Frequently Asked Questions ” and choose question six.

To read more about how the BLS measures price changes, see the BLS online publication “How BLS Measures Changes in Consumer Prices .”

The Basics - What is Inflation?

Inflation is generally defined by the BLS as "a process of continuously rising prices, or equivalently, of a continuously falling value of money." The CPI compares the prices of a set of goods and services relative to the prices of those same goods and services in a previous month or year. Changes in the prices of those goods and services approximate changes in the overall level of prices paid by consumers.

If the prices of goods and services increase, the purchasing power of a dollar of income decreases. If prices increase by 5 percent, and your income remains the same, you can't purchase as many goods and services with your income. If your income increases by 5 percent and prices increase by 5 percent, the inflation negates your increase in income. Your 'real' income does not increase.

When prices decrease and income remains constant, real income increases. If your nominal income increases by 5 percent and the price level decreases by 1 percent, your real purchasing power increases by 6 percent.

Recent U.S. Inflation Trends

Figure 2 shows recent inflation data reported for each month. It is obvious that the monthly inflation figures change a great deal from one month to the next. Look at how the monthly increases have been higher over the most of the last two and a half years and have reversed dramatically in recent months.

 

Inflation Figure 2

 

Figure 3 shows the changes in the core index compared to the changes in the overall CPI. Obviously the changes in prices other than energy and food have been significantly smaller than the changes in the overall index. That is due to the much greater volatility in energy and food prices.

 

Inflation Figure 3

 

Core Inflation

The media often mentions the “core rate” of inflation and the “headline rate.” What’s the difference?

Typically, changes in the CPI or inflation are reported in the media in two ways, 1) The CPI (all sectors) and 2) the 'core' rate of inflation that excludes food and energy prices. The overall CPI data is often referred to as the 'headline number' because that number is reported in the news.

Extra attention is given by forecasters to the core index as it tends to show more lasting trends in prices. The rates of change in the core index were higher in the early part of the year and that did cause concern about the trend in inflation. The concern is that the increase in energy prices over the last several years may have started to influence rates of increases in all other prices. While that concern still exists, core prices are increasing at relatively slower rates. Recent decreases in energy prices have somewhat reduced the difference between the reported rate and the core rate.

Energy and food prices have historically fluctuated more than other (core) prices. October is a good example. According to the BLS, the energy price index fell 8.6 percent in October following declines of 1.9 percent in September and 3.1 percent in August. Motor fuel prices fell 14.2 percent in October. Gasoline prices reached over $4.00 a gallon just a couple of months ago and now have dropped to around $2.00. Planners and business owners have a difficult time factoring in prices that change so rapidly.

The media will now commonly report that the annual rate of (headline) inflation is now just 3.7 percent, down from the 4.9 percent annual rate increase reported in September. Core inflation reported at an annual rate is now just 2.2 percent.

Wait a Minute! Aren’t Lower Prices Good News?

Consumers may read the news about lower prices and feel better, given all of the recent bad economic news. Their incomes can now purchase just a little bit more. Whether or not this is good news, depends on whether the consumers are purchasing the goods and services that have decreased in price. In October, some prices increased and others did not. If the "general price level" decreases over a period of time, "deflation" results.

A November 20, "New York Times" article by Vikas Bajaj addressed the potential for and the impact of deflation.

"The Labor Department reported that prices of consumer goods and services fell by a record amount in October, while another report showed that a measure of home building fell for the fourth straight month, to its lowest level in the 49 years that the government has kept that data.

While most consumers might welcome the idea that things are getting cheaper, deflation is an economists’ nightmare. It was a hallmark of the Depression and Japan’s so-called lost decade in the 1990s. A big worry is that deflation would blunt the impact of interest rate cuts by the Federal Reserve, forcing policy makers to use other tools to try to revive the economy."

"The vice chairman of the Fed, Donald L. Kohn, said that the risk of deflation, defined as a “general decline in prices,” remained slight but had increased. “Whatever I thought that risk was, four or five months ago, I think it is bigger now even if it is still small,” Mr. Kohn said in response to a question after a speech. The Fed, he added, would be aggressive, if necessary, to prevent a broad drop in prices.

"Analysts say a sustained decline in consumer prices would be terrible for the economy. Businesses that cut prices to attract buyers are likely to have to lay off workers as well. They may also have little left over to pay lenders or shareholders.

Prices are falling outside the United States too. Consumer prices declined in Britain, France, Germany and elsewhere in Europe in October, and prices were flat in September in Japan, which has fought deflation on and off for nearly two decades.

The decline in consumer prices is all the more remarkable because this summer many economists were concerned about inflation and the prospect for stagflation, in which inflation and unemployment rise simultaneously, contrary to their usual relationship. “It’s funny that just a few months ago everyone was wringing their hands over inflation,” said Nariman Behravesh, chief economist at Global Insight. “It’s gone. It’s over.”

""It would take significant and persistent contraction in the economy to push core inflation into negative territory,” said Dean Maki, an economist at Barclays Capital in New York. “We do not think that is likely, especially given the aggressive policy response on the part of the Fed and Treasury.”"

Students: Read the above excerpts from Vikas Bajaj's New York Times article. Are we headed for "deflation"? What will have to happen i n the economy for "deflation" to result?

CONCLUSION

The general price level in the United States, as measured by the Consumer Price Index decreased by 1.0 percent in October 2008. The price decrease seems to be a predictable result of the overall decline in U.S. economic activity. The demand for many productive resources has decreased and unemployment has increased. Excluding energy and food, the price level was essentially unchanged. The October decrease was met with speculation about the possibility of "deflation" and further deteriorating economic conditions.

These case studies over the past few years have often raised questions about the impact of inflation and its impact on consumers, investors, producers and government planners.

  • How will consumers respond if their purchasing power diminishes.
  • How will investors react when the real returns of their investments decrease?
  • Will producers cut back when input costs increase?
  • How do planners manage budgets when faced with rising prices?

For now, these questions may be just the opposites. What is the impact of lower prices on their behaviors?

ASSESSMENT ACTIVITY

Next, answer the below questions by putting your answers in the interactive notepad below.

 

  1. Which measurement, the CPI-U or the core rate, is the most meaningful?
     
  2. Why would someone say that borrowers benefit from unanticipated inflation?

EXTENSION ACTIVITY

How Much Do You Weigh in the CPI?

The BLS announcement mentions, “In calculating the index, price changes for the various items in each location are averaged together with weights, which represent their importance in the spending of the appropriate population group.” This recognizes that people do not have the same spending patterns. This also means that price level changes for various goods and services affect people differently.

A high school student who spends a large portion of his or her income on transportation, clothing and entertainment is more greatly affected if those prices change. If you do not pay rent, housing prices are not a very important part of your cost of living. When the price of gasoline falls, the student who spends much of his or her income on gasoline will gain purchasing power.

When housing costs (rents or rental equivalents) increase, the family that spends a large portion of their income on rent may lose purchasing power, even if other prices do not increase as much. Someone who lives in a large city and does not drive may not be affected very much by changes in gasoline prices.

Go to: “The Consumer Price Index--Why the Published Averages Don't Always Match An Individual's Inflation Experience

Determine your own 'Personal Price Index,' by determining the percentage of your spending in each category. This will give you your own 'weights' for each spending category. See the 'hypothetical individual' example in the reading.

How are you affected by inflation compared to the average urban consumer and each other? Do you spend a larger percentage of your income on automobiles, gasoline or entertainment?

How does inflation impact you, your family and other demographic groups?
 

Presidential Advisor Role-play

Role-play different groups who are impacted by inflation and the possibility of deflation.

  • Average consumers
  • Producers/business owners
  • Retired or unemployed people
  • Government planners
  • People who owe money
  • Bankers with outstanding loans

Assign students to one of the groups.

Directions:

You have been invited to make a two minute presentation to President-elect Barack Obanma about how you are impacted by inflation or deflation. How much priority do you think the President should give to the prospects for deflation in his new policies?